THIN CAPITALIZATION IN INDIA
1.0
INTRODUCITON
A company is
said to be thinly capitalized when a greater proportion of its
‘capital-structure’ is made up of ‘debt’ than of ‘equity’. The interest
payments generated on ‘debt capital’ is treated as a finance charge, and is
allowable as a deduction in the taxable corporate income, thereby reducing the
corporate tax burden. On the contrary, the dividend distribution tax is payable
by enterprises on their after-tax profits, and if there is no profit dividend
is not payable.
Hence, higher
proportion of debt results in tax avoidance. To prevent such abuse, separate
rules had been introduced in many countries. These rules are known as ‘thin
capitalization rules’.
2.0
THIN CAPITALIZATION IN WORLD
Tax-authorities
in several countries treat ‘debts’ accepted beyond certain limits from controlling
shareholders as ‘veiled-capital’ and term it as ‘thin capital’(also known as
‘hidden capital’) to distinguish it from normal loans. Interest paid on that
part of the debt which is rechristened as ‘thin capital’ will be treated as
‘dividend’. Dividend, being expenditure disallowed, will be added back to the
total income of the company and assessed to tax. This way, the tax avoided is
restored by restructuring ‘debt’ into ‘thin cap’ and ‘debt’. This sort of
capital-structure is recognized only for the purpose of Tax Legislation.
Many countries
like Australia, Germany, France, Japan, China and USA have incorporated specific
Thin Capitalization rules in their jurisdiction to deter erosion of the tax
base through excessive interest payments.
But, since the
concept stands in the way of free flow of investment, many other countries have
not yet recognized it. India is one among them. Indian Tax Legislation does not
have separate rules for ‘thin capital’-neither does it directly recognize the
concept.
3.0
POSITION IN INDIA
It is pertinent
to note that ‘foreign investors’ can take advantage of the same and invest in
India. The deduction of tax at source on interest payment to foreign company is
5% under Section 194LC of the Income Tax Act, 1961 (“the Act”) otherwise at the
“rates in force” under Section 195(1) of the Act while in Double Taxation
Avoidance Agreement (“DTAA”), the withholding tax rate lies in the range of 10%-20%
with the treaty countries.
On top of it,
the dividend paid by an Indian Company are subject to Dividend Distribution Tax
(“DDT”) under Section 115-O of the Act at an effective rate of 16.995%. In this regard, it is worthwhile to refer to
the second proviso to Section 195(1) of the Act. The relevant extract has been
reproduced below:
“Provided further that no such
deduction shall be made in respect of any dividends referred to in Section
115-O”
Further,
reference may be had to Section 10(34) of the Act. The relevant extract has
been reproduced below:
“In computing the total income of a previous year of
any person, any income falling within any of the following clauses shall not be
included—
(1).....
(2)....
(34)
any income by way of dividends referred to in section 115-O;”
From the perusal
of the above, it can be seen that the aforesaid remittance of dividend is not
taxable after paying tax on distributed profits at an effective rate of 16.995%
in terms of Section 115-O of the Act. To avoid double taxation (Corporate tax
and DDT) of the Corporate Income, the Foreign Company can claim credit on the
tax paid in India with reference to Underlying Tax Credit method while the
credit would be available for DDT or not is not free from doubt.
Chapter X of the
Income Tax Act, 1961 provides special provisions relating to Avoidance of Tax.
But it does not recognize ‘thin cap’. Also the Act is silent on taxing deemed dividend
in the place of interest paid to ‘thin capital’, even though it defines certain
other dividends, under section 2(22), which are deemed as dividend. In other
words the Act defines deemed dividend, but does not include interest on ‘thin
cap’.
In this regard,
reference can be made to Bombay High Court decision in the case of Director of
Income-tax, International Taxation-II, Mumbai v. Besix Kier Dabhol SA [ITA No. 776 of 2011] wherein the facts are as
follows:
“Assessee, a non-resident
company had borrowed money from its shareholders in same ratio as equity
shareholding resulting in abnormal debt-equity ratio of 248:1. Revenue's contended
that debt was to be re-characterised as equity and interest payment thereon
disallowed. The High Court ruled in favour of assessee and held that since
there are no thin capitalization rules in force, interest payment on debt
capital to shareholders could not be disallowed”
4.0
Foreign Exchange Management Act, 1999 (FEMA) and Regulations
It would be pertinent
to note that the RBI Master Circular No. 12/2013-14 on External Commercial
Borrowings (ECB) and Trade Credits stipulates a debt equity ratio of 4 : 1 for borrowings
by Indian Entity from ‘‘Recognized Lenders’’ in excess of US $ 5 Million from
‘‘Foreign Equity Holders’’. The Foreign Equity Holders should hold a minimum of
25% of the paid-up equity of the eligible borrower. Further the regulations
clarify ‘‘i.e. borrowing the proposed ECB not exceeding four times the direct
foreign equity holding’’. This adds a new dimension to the basic question of
Debt Equity ratio. This circular will stand withdrawn on July 1, 2014 and be replaced
by an updated Master Circular on the subject.
5.0
DIRECT TAX CODE, 2010
Of late, the
Government of India is seriously considering steps to prevent ‘all
arrangements’ to avoid tax. The change proposed in General Anti Avoidance Rules
(GAAR) is a step in that direction. The Direct Taxes Code (DTC) intends to
widen the scope of the said GAAR so as to include in its purview all arrangements
which aim to avoid tax without violating the express provisions of the Code.
‘Thin Capitalization’ is considered as one such arrangement to avoid tax and
hence may come under the purview of GAAR. It is in this context that the
awareness of the concept gains importance.
The possible
consequences for an impermissible avoidance arrangement can be that the
arrangement could be disregarded in part or in full or, combined or re‑characterized in part or in
whole. One of the types of re-characterization contemplated under Clause
123(1)(f) of DTC is re-characterization of debt as equity, and vice versa.
Interestingly, for the purposes of anti-abuse provisions, interest has been
defined to include dividends.
6.0
GENERAL ANTI – AVOIDANCE RULES (GAAR)
The GAAR
provisions will come into effect only if the assessee enters into an
impermissible avoidance arrangement as defined in Section 96(1) of the Act.
On 17th
July 2012, the Prime Minister had constituted an Expert Committee under the
chairmanship of Dr Parthasarathi Shome to engage in extensive consultation
process and finalize the GAAR guidelines.
On 30th
September 2012, the Expert Committee submitted its Final Report on GAAR
provisions. It provides guidance on Thin Capitalization through key
illustration as follows; an Indian Company raising funds from a foreign company
incorporated in a low tax jurisdiction outside India through borrowings, when
it could have issued equity is not covered by GAAR. In such case, there is no
specific provision dealing with thin-capitalization in the Act. An evaluation
of whether a business should have raised funds through equity instead of debt
should generally be left to commercial judgment of a taxpayer. The onus will be
on the Revenue to identify the scheme and its dominant purpose.
However, GAAR
would apply to a case where the interest rate is linked to actual profits and
it appears that an actual equity investment is disguised as debt to obtain a
tax benefit.
Similarly, GAAR
would apply to a case where a loan is assigned to a resident of a country which
has favourable treaty with the view of avoiding withholding tax in India on
interest.
After due
consideration of the Final Report of the Expert Committee headed by Dr.
Parthasarathi Shome and the Recommendations made therein, the Government of
India has made GAAR applicable from the FY 2015-16 and the monetary threshold
of Rs. 3 crores of tax benefit in the arrangement has been accepted for
invoking GAAR. GAAR not to apply
retrospectively and hence to apply only to income arising to the
taxpayer on or after GAAR provisions come into force. It is to be noted that
the statement made by the Finance Minister does not contain any recommendation
on funding through debt or equity.
7.0
BENCHMARKING OF TRANSACTION
As per Finance
Minister’s speech in 2013, the assessee shall have an opportunity to prove that
the arrangement is not an impermissible avoidance arrangement. A connected
person, who had invested in the “debt capital” of the taxpaying company, may
enable the company to take shelter under ‘ALP-safe harbor’ if and when he does the
following:
(i)
Ascertain how much the company would
have been able to borrow from an independent lender; and
(ii)
Compare this with the amounts actually
borrowed from group companies or with the backing of group companies.
(iii)
Consider whether the rate of interest is
one which would have been obtained at arm’s length rate while comparing from an
independent lender as a standalone entity.
A comparison can
then be made between the interest payable on the actual debt and that which
would be payable on the amount which could have been borrowed at arm’s length. Sometimes
the difference may be nil; in which case it can be established that the debt
falls under ‘ALP shelter’.
8.0 BASE EROSION AND PROFIT SHIFTING (BEPS)
The term "base erosion and profit shifting" means, tax planning
strategies that exploit gaps and mismatches in tax rules to make profits
'disappear' for tax purposes or to shift profits to locations where there is
little or no real activity but the taxes are low resulting in little or no
overall corporate tax being paid. India being a
non-OECD member is a member of BEPS as it is a member of G-20 countries.
The Action plan 2 of BEPS is “Neutralise the effects of hybrid mismatch
arrangements” which develops model
treaty provisions and recommendations regarding the design of domestic rules to
neutralise the effect (e.g. double non-taxation, double deduction, long-term
deferral) of hybrid instruments and entities. This work will be co-ordinated with
the work on interest expense deduction limitations, the work on Controlled Foreign
Company (CFC) rules, and the work on treaty shopping.
On 19th March, 2014 the OECD publishes the Discussion Draft on
Action Plan 2. The timeline for completion of the Action plan is expected to be
September 2014, although it may take longer for the impact of these changes to
be fully applied in practice.
9.0
WAY FORWARD
The coverage of
“connected person” in GAAR definition is wide as defined in Section 102 of the
Act which may potentially even include strategic investors and lenders who
otherwise may not have had an intention of becoming an affiliated entity. While the anti-avoidance and
thin capitalization principle introduced in the Direct Taxes Code and GAAR
report is a welcome step, the Government needs to simultaneously take the next
step and provide the required guidance upfront to multinational enterprises as
to how the capital structures (debt-equity) should be formed or maintained and
the principles to be adopted while evaluating them for arm’s length, commercial
substance and bona fide nature.
Announcing a Safe Harbor on debt-equity ratios for different types of
industries in different stages of project cycle could be one of the options
that the Revenue authorities could consider to alleviate the concerns of
various commercial concerns. If no specific rules or safe harbors are
announced, it would leave the capital structure and debt-equity ratio of
multinational enterprises to be benchmarked against prevailing industry
practices and norms, though traditional methodologies for arm’s length
benchmarking would be found inadequate for this purpose. We
have seen the confusion created by the RBI Master circular while stipulating
the debt-equity ratio with respect to ECB from foreign equity holders.
Moreover, if the
arrangement is for more than Rs. 3 Crores, then only it will fall under the ambit
of GAAR provisions and there is no separate indication when to re-characterize equity
into debt. The GAAR also gives room to double taxation as applying arm’s length
concept for determining the correct debt equity ratio in India while trying to
qualify within the statutory debt equity ratio in the other country, would be a
very delicate matter.
So, still there
is no clarity in application of Thin Capitalization in India and foreign
companies can invest in India keeping in mind the application of GAAR provisions
from the FY 2015-16 onwards. The effect of thin
capitalization must be closely studied by each corporate, since it may have
consequences for the business structures currently employed by companies.
Author :
Kushal Agarwala
B.Com, CA (Final) and CS (Final)
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